The Curious Schemer

(Disclosure: at this moment, I do NOT own any VMWare shares. I just picked it because it’s the most interesting one to watch these days.)

Man oh man! VMWare just keeps skyrocketing! If you had bought VMW only 3 days ago (October 22, 2007), you’d have got a 10% return off your money in just 3 days now. As I’m typing this, VMW shares are traded at $111.25 during the pre-market hours… and keeps rising. Boom it goes up to $111.26 just as I finished typing the previous sentence!

All of this is very exciting. But they’re all paying too much.

No, I’m not going to point out that the stock is wayyy overpriced like gazillion others have like all the others out there have. I believe that although fundamental analysis is valid, one should ride a trend when the trend is his friend. I’m saying they’re all paying too much because there’s a way of buying VMWare at around $70+ today, and still enjoy the same upward (and downward) movement that VMW has. How? Read on.

You’ve got to LEAP, baby

Say, you’re sure that virtualization is king. You’re convinced that VMWare is the king of this, er, king. Your research has told you that after their glowing Q3 report, the price will probably go up to, say, $130, within say, 3 months. So you want to invest now. NOW! Catch the trend while it’s hot, yadda yadda.

Let’s see. To get one lot of VMW, you need around… wait let me check, $11,150 (excluding commission) now. If it gets up to $130 per share, that’s a profit of around $1,800–around 16%. Quite neat for just 3 months! But what happens if you get it at $72? One lot costs $7,200, and if it gets up to $130 per share, that’s a profit of around $1,800… which is instead of 16% is now a respectable 25% out of the initial investment. Nice!

Here’s how: instead of buying this, buy this instead. The screen capture is shown below.

As you can see, the asking for this KJCAH.X thing is $74.60. Much lower than the real VMW price. But it tracks the VMW movement exactly. What are these things? They are called Long-Term Equity Anticipation Securities, a.k.a.: LEAPS (more info also available here). More specifically, it’s called Deep In The Money call options. Yes, options. The very thing that many investment gurus tell you to stay the heck away from. I suspect that’s because they don’t know options very well themselves.

Basically, for this thing to work, you need to make sure that the following conditions are followed:

1. The option’s delta must be as close to 1 (that is, 100%) as possible. When it’s 1, the option price is tracking the stock price almost exactly. That is, if VMW goes up by $10, the option price goes up by $10 as well.
2. The expiration date must be as far away as possible in the future. This way you’re less affected by the option decay, and instead you can hold it for longer term, almost like holding the stocks themselves.

In fact as I realized this, I wonder why a lot of people haven’t done this. I discussed this with a bunch of friends and colleagues and although they seem to agree that they see no hole in this scheme, they remain unenthusiastic about it. Which I just can’t understand. You can buy a stock for way less, almost half the price! What more do you want?

Then one friend said, “Well, you test it, and let me know.”

Weird. I guess they’re probably unconvinced because I haven’t made gazillions of dollars using this method. Just like Einstein haven’t shown how to make one twin older than the other by making the other travel near the speed of light… oh wait. People are actually convinced by that one. Oh well. Apparently I’m no Einstein.

If you do see a hole/downside (other than the fact that it has a 3-year expiration, whereas for the shares you can hold it longer, although for the life of me I can’t imagine why anybody would want to keep a stock longer than 3 years if it hasn’t performed as he/she expected), please share it in the comments section!

UPDATE: I think I should clarify more. In that screen capture above, the Strike price for the option is $40. So doesn’t it mean that if I buy the option for $70, I’m buying it at $110 actually (the price of the option + the strike price of the VMW stock)?

Yes, the thing is that I never intend to exercise the option in the first place. What I want to get is the movement of the stock (which is mimicked in lockstep by the option), but not at the price of the stock itself. When the option price moves up because its intrinsic value moves up, I intend to sell it back at a profit. The strike price then is not a factor here.